| KMG CHEMICALS INC ITEM 1A RISK FACTORS You should carefully consider the risks described below, together with all of the other information included in this report |
| We believe the risks and uncertainties described below are the most significant we face |
| The occurrence of any of the following risks could materially harm our business, financial condition or results of operations |
| In that case, the trading price of our common stock could decline, and you may lose all or part of your investment |
| Additional risks and uncertainties not presently known to us or that we currently deem immaterial may also impair our operations |
| Risks Relating to Our Business We may experience a reduced demand for our wood preserving chemicals if the demand for the wood products on which those chemicals are used decreases, which may adversely affect our business, results of operations, cash flow and financial condition |
| Our wood preserving chemicals, penta and creosote, which represented 82prca of our total revenues in fiscal year 2006, are sold into mature markets |
| The principal consumers of our wood preserving chemicals are industrial wood treating companies who use our products to protect wood utility poles and railroad crossties from insect damage and decay |
| Although these products are sold into relatively stable markets, the demand for treated wood generally increases or decreases with the financial strength and maintenance budgets of electric utilities and railroad companies |
| Penta is used primarily to treat utility poles in the United States |
| In recent years, utility pole demand has generally declined, as we believe electric utilities in the United States have reduced their maintenance spending due to competitive pressures arising from deregulation |
| Although utility pole demand has recently increased, deregulation may continue to negatively affect the utility pole market |
| The preservation of wood railroad crossties represents the largest market for creosote in the United States |
| We believe that since January 2001 average annual purchases of wood crossties by United States and Canadian railroads have ranged from approximately 14dtta0 million to 19dtta0 million |
| If the current purchase rate declines, or if railroads shift significantly to a greater use of non-wood ties, such as those made with concrete or plastic, we will experience a decline in our creosote sales |
| A decline in either utility pole or wood crosstie sales could have a material adverse effect on our business, financial condition and results of operations |
| Increases in the price of our primary raw materials may decrease our profitability and adversely affect our liquidity and cash flow |
| Chlorine is a key component in the manufacture of penta |
| Although we have been able to achieve significant price increases for penta since July 2002, these increases have not been sufficient to maintain the previous profitability of that product |
| High energy prices have increased the competition for creosote, since it can be burned as a fuel in certain markets |
| Creosote is produced by our suppliers from the distillation of coal tar |
| Coal tar supplies, particularly in the United States, are in short supply, a situation which we expect will continue indefinitely |
| Historically, the cost of our creosote has increased each year, and we believe that it will continue to increase |
| The prices we pay for our raw materials have increased significantly in the last several years, and we have not always been able to fully and timely pass those increases through to our customers |
| In the future, we may be unable to fully and timely pass on increases in our raw material costs, and raw material price increases may erode the profitability of our products by reducing our gross margins |
| Price increases for raw materials 8 ______________________________________________________________________ may also increase our working capital needs, which could adversely affect our liquidity and cash flow |
| For these reasons, we cannot assure you that raw material cost increases will not have a material adverse effect on our financial condition and results of operations |
| If our products are not re-registered by the EPA or are re-registered subject to new restrictions, our ability to sell our products may be curtailed or significantly limited |
| Our creosote, penta and MSMA products, and many of our animal health products, are presently undergoing re-registration review by the EPA under FIFRA We have submitted and will submit a wide range of scientific data to support our US registrations |
| In order to be re-registered, we are required to demonstrate, among other things, that our products will not cause unreasonable adverse effects on human health or the environment when used according to approved label directions |
| The EPA has issued its preliminary risk assessments for creosote and penta, and has identified certain risks to human health and the environment |
| In August 2006, the EPA issued a preliminary re-registration eligibility decision and concluded that MSMA is not eligible for re-registration |
| Alone and with other registrants of these products, we have provided and will provide comments and data on the preliminary risk assessment for creosote and penta, and on the re-registration eligibility decision for MSMA, to show to the EPA that our products do not pose unreasonable risk to human health and the environment when used in accordance with approved label directions |
| We cannot assure you as to when or if the EPA will issue a final decision concluding that our creosote and penta products, and our animal health pesticides and agricultural chemicals, do not pose an unreasonable risk to human health or the environment when used in accordance with approved label directions |
| We also cannot assure you as to when or if those products will be re-registered by the EPA, or if re-registered, what use or labeling restrictions might be required to obviate or mitigate risks identified by the EPA Even if our products are re-registered by the EPA, we cannot assure you that our products will not be subject to further data submission requirements, or subject to use or labeling restrictions, that have an adverse effect on our financial position and results of operations |
| The failure of our current or future-acquired products to be re-registered by the EPA or the imposition of new use, labeling or other restrictions in connection with re-registration would have a material adverse effect on our financial condition and results of operations |
| Our products may be rendered obsolete or less attractive by changes in regulatory, legislative, and industry requirements or by supply-chain driven pressures to shift to environmentally preferable alternatives |
| Changes in regulatory, legislative and industry requirements, or changes driven by supply-chain pressures, may shift current customers away from products using penta, creosote or certain of our other products and toward alternative products that are believed to have fewer environmental effects |
| The EPA, foreign and state regulators, local governments, private environmental advocacy organizations and a number of large industrial companies have proposed or adopted policies designed to decrease the use of a variety of chemicals, including penta, creosote and others included in certain of our products |
| Our ability to anticipate changes in regulatory, legislative, and industry requirements, or changes driven by supply-chain pressures, will be a significant factor in our ability to remain competitive |
| Further, we may not be able in the future to comply with changed or new regulatory or industrial standards that may be necessary for us to remain competitive |
| We cannot assure you that the EPA, foreign and state regulators and local governments will not restrict the uses of penta, creosote or certain of our other products or ban the use of one or more of these products, or that the companies who use our products may decide to significantly reduce or cease the use of our products voluntarily |
| 9 ______________________________________________________________________ We are dependent on a limited number of suppliers for cosolvent, creosote and one of our animal health pesticides, the loss of any one of which could have a material adverse effect on our financial condition and results of operations |
| We depend on two major suppliers for the cosolvent needed to produce the liquid formulation of our penta product |
| Both of these suppliers produce cosolvent as a byproduct of a process intended to manufacture a higher value product |
| Changes in that process or in market conditions affecting the higher value product could materially affect the availability or price of cosolvent |
| Our creosote is supplied primarily by two suppliers |
| There are no other significant suppliers of creosote for the North American market |
| We have one major supplier and one minor supplier of the tetrachlorvinphos active ingredient for our Rabon and Ravap products, and only one supplier for each of two other active ingredients in our animal health pesticides, dichlorvos and endosulfan |
| If we were to lose any of these suppliers, we might have difficulty securing a replacement supplier at reasonable cost, and no assurance can be given that such loss would not have a material adverse effect on our financial condition and results of operations |
| Weather may adversely impact our ability to conduct business |
| The supplier of approximately one-half of our creosote is based in Europe |
| As such, we are dependent on terminals located in coastal areas for the importation of a substantial portion of the creosote we use |
| These terminals are vulnerable to hurricanes and other adverse weather conditions that have the potential to cause substantial damage to terminal facilities and interrupt our importation of creosote |
| For example, in 2005 Hurricane Katrina forced us to temporarily close our terminal in New Orleans, Louisiana and locate an interim substitute terminal |
| We cannot assure you that adverse weather conditions will not affect our importation of creosote in the future, the occurrence of which could have a material adverse effect on our financial condition and results of operations |
| If we are unable to identify, fund and execute new acquisitions, we will not be able to execute a key element of our business strategy |
| Our strategy is to grow primarily by acquiring additional businesses and product lines |
| We cannot assure you that we will be able to identify, acquire or profitably manage additional businesses and product lines, or successfully integrate any acquired business or product line without substantial expenses, delays or other operational or financial difficulties |
| Financing for acquisitions may not be available, or may be available only at a cost or on terms and conditions that are unacceptable to us |
| Further, acquisitions may involve a number of special risks or effects, including diversion of management’s attention, failure to retain key acquired personnel, unanticipated events or circumstances, legal liabilities, impairment of acquired intangible assets and other one-time or ongoing acquisition-related expenses |
| In addition, we cannot assure you that acquired businesses or product lines, if any, will achieve anticipated revenues and earnings |
| The consideration we pay in connection with an acquisition also may affect our financial results |
| If we were to proceed with one or more significant acquisitions in which the consideration included cash, we could be required to use a substantial portion of our available cash or obtain debt or equity financing |
| To the extent that we issue shares of our capital stock or other rights to purchase shares of our common stock as consideration for an acquisition or in connection with the financing of an acquisition, including options or other rights, our existing common shareholders may be diluted, and our earnings per share may decrease |
| 10 ______________________________________________________________________ If we are unable to successfully position ourselves in smaller niche markets, our business may be adversely affected |
| We are positioned in smaller niche markets that have been or are being abandoned by larger chemical companies |
| These markets tend not to attract larger chemical companies due to lower volume demand |
| As a result, larger chemical companies have been divesting themselves of products and businesses that fall into these smaller markets where our acquisition efforts are focused |
| Larger companies sometimes market and sell newer competing products using other technologies or containing different active ingredients, and their sales efforts may shift demand to these newer products and depress sales of the older products |
| Thus, we cannot assure you that we will be successful or continue to be successful in niche markets |
| The specialty chemical industry is highly competitive, and we may not be able to compete effectively with our competitors, which could adversely impact our results of operations |
| The specialty chemical industry is highly competitive |
| Competition in specialty chemicals is based upon a number of considerations, such as the size of our competitors, competition for raw materials, product innovation, product range and quality, relationships with customers, reliability of delivery, technical support and distribution capability, and price |
| Among the participants in the specialty chemical industry are some of the world’s largest chemical companies and major integrated petroleum companies that have their own raw material resources |
| Some of these companies may be able to produce products more economically than we can |
| In addition, some of our competitors have greater financial resources, which may enable them to invest significant capital into their businesses, including expenditures for research and development |
| If any of our current or future competitors develops proprietary technology that enables them to produce products at a significantly lower cost, our technology could be rendered uneconomical or obsolete |
| Increased competition in any of our business segments could compel us to reduce the price we receive for our products, which could result in reduced profit margins and/or loss of market share |
| Restrictions in our debt agreements could limit our growth and our ability to respond to changing conditions |
| Our revolving credit facility and the senior credit facility with Wachovia Bank, NA contain a number of significant covenants which affect our ability to take certain actions and restrict our ability to incur additional debt |
| These include covenants that prohibit acquisitions that are not approved by Wachovia Bank |
| In addition, our revolving credit facility requires us to maintain certain financial ratios and satisfy certain financial condition tests, which may require us to take action to reduce our debt or take some other action to comply with them |
| These restrictions could limit our ability to obtain future financings, make needed capital expenditures, withstand a future downturn in our business or the economy in general or otherwise conduct necessary corporate activities |
| We may also be prevented from taking advantage of business opportunities that arise because of the limitations that these restrictive covenants impose on us |
| A breach of any of these covenants would result in a default under the applicable debt agreement |
| A default, if not waived, could result in acceleration of the debt outstanding under the agreement and in a default with respect to, and acceleration of, the debt outstanding under our other debt agreements |
| The accelerated debt would become immediately due and payable |
| If that should occur, we may not be able to pay all such debt or to borrow sufficient funds to refinance it |
| Even if new financing were then available, it may not be on terms that are acceptable to us |
| 11 ______________________________________________________________________ The distribution and sale of our products is subject to prior governmental approvals and thereafter ongoing governmental regulation |
| Our products are subject to laws administered by federal, state and foreign governments, including regulations requiring registration, approval and labeling of our products |
| The labeling requirements restrict the use and type of application for our products |
| More stringent restrictions could make our products less desirable which would adversely affect our sales and profitability |
| All of our products are subject to the EPA’s registration and re-registration requirements, and are conditionally registered in accordance with FIFRA Those registration requirements are based, among other things, on data demonstrating that the product will not cause unreasonable adverse effects on human health or the environment when used according to approved label directions |
| All states where our products are used also require registration before they can be marketed or used in that state |
| Governmental regulatory authorities have required, and may require in the future, that certain scientific testing and data production be provided on our products |
| We have and are currently furnishing certain required data relative to our products |
| Under FIFRA, the federal government requires registrants to submit a wide range of scientific data to support US registrations |
| This requirement significantly increases our operating expenses, and we expect those expenses will continue in the future |
| Because scientific analyses are constantly improving, we cannot determine with certainty whether or not new or additional tests may be required by regulatory authorities |
| While Good Laboratory Practice standards specify the minimum practices and procedures which must be followed in order to ensure the quality and integrity of data related to these tests submitted to the EPA, there can be no assurance that the EPA will not request certain tests or studies be repeated |
| In addition, more stringent legislation or requirements may be imposed in the future |
| We can provide no assurance that our resources will be adequate to meet the costs of regulatory compliance, or that the cost of such compliance will not adversely affect our profitability |
| We are subject to extensive environmental laws and regulations and may incur costs that have a material adverse effect on our financial condition as a result of violations of or liabilities under environmental laws and regulations |
| Like other companies involved in environmentally sensitive businesses, our operations and properties are subject to extensive and stringent federal, state, local and foreign environmental laws and regulations, including those concerning, among other things: · the treatment, storage and disposal of wastes; · the investigation and remediation of contaminated soil and groundwater; · the discharge of effluents into waterways; · the emission of substances into the air; and · other matters relating to environmental protection and various health and safety matters |
| The EPA and other federal and state agencies, as well as comparable agencies in Mexico and in other countries where we sell our products, have the authority to promulgate regulations that could have a material adverse impact on our operations |
| These environmental laws and regulations may require permits for certain types of operations, requires the installation of expensive pollution control equipment, place restrictions upon operations or impose substantial liability for pollution resulting from our operations |
| We expend substantial funds to minimize the discharge of hazardous materials in the environment and to comply with governmental regulations relating to protection of the environment |
| Compliance with environmental and health and safety laws and regulations has resulted in ongoing costs for us, and could restrict our ability to modify or expand 12 ______________________________________________________________________ our facilities or continue production, or require us to install costly pollution control equipment or incur significant expenses, including remediation costs |
| We have incurred, and expect to continue to incur, significant costs to comply with environmental and health and safety laws |
| Federal, state and foreign governmental authorities may seek fines and penalties, as well as injunctive relief, for violation of the various laws and governmental regulations, and could, among other things, impose liability on us for cleaning up the damage resulting from a release of pesticides, hazardous materials or other chemicals into the environment |
| Our use of hazardous materials exposes us to potential liabilities |
| Our manufacturing and distribution of chemical products involve the controlled use of hazardous materials |
| Our operations, therefore, are subject to various associated risks, including chemical spills, discharges or releases of toxic or hazardous substances or gases, fires, mechanical failure, storage facility leaks and similar events |
| Our suppliers are subject to similar risks which may adversely impact the availability of raw materials |
| While we adapt our manufacturing and distribution processes to the environmental control standards of regulatory authorities, we cannot completely eliminate the risk of accidental contamination or injury from hazardous or regulated materials, including injury of our employees, individuals who handle our products or goods treated with our products, or others who claim to have been exposed to our products, nor can we completely eliminate the unanticipated interruption or suspension of operations at our facilities due to such events |
| We may be held liable for significant damages or fines in the event of contamination or injury, and such assessed damages or fines could have a material adverse effect on our financial performance and results of operations |
| Our business success depends significantly on the reliability and sufficiency of our manufacturing facilities |
| Our revenues depend significantly on the continued operation of our manufacturing facilities |
| The operation of our facilities involves risks, including the breakdown, failure, or substandard operation or performance of equipment, power outages, explosions, fires, natural disasters and other unscheduled downtime |
| The occurrence of material operational problems or the loss or shutdown of our facilities over an extended period of time due to these or other events could have a material adverse effect on our financial performance and operating results |
| Our business is subject to many operational risks for which we may not be adequately insured |
| We cannot assure you that we will not incur losses beyond the limits of, or outside the coverage of, our insurance policies |
| From time to time, various types of insurance for companies in the chemical industry have not been available on commercially acceptable terms or, in some cases, have been unavailable |
| In addition, we cannot assure you that in the future we will be able to maintain existing coverage or that premiums will not increase substantially |
| We maintain limited insurance coverage for sudden and accidental environmental damages |
| We do not believe that insurance coverage for environmental damages that occur over time is available at a reasonable cost |
| Also, we do not believe that insurance coverage for the full potential liability that could be caused by sudden and accidental incidences is available at a reasonable cost |
| Accordingly, we may be subject to an uninsured or under-insured loss in such cases |
| 13 ______________________________________________________________________ We may experience a reduction in demand for creosote if our customers dilute creosote with fuel oil prior to treating |
| If creosote begins selling at a premium to fuel oil, it is likely that some of our customers would dilute creosote with fuel oil |
| If dilution were to occur on a widespread basis, we could see a significant decline in our creosote sales |
| A decline in creosote sales could have a material adverse effect on our results of operations |
| Our business may be adversely affected by cyclical and seasonal effects |
| In general, the chemical industry is cyclical and product demand for certain products is seasonal |
| Many of our products are used in industries that are cyclical in nature |
| Changes affecting these industries can adversely affect our revenues and margins |
| Seasonal usage of our chemical products follows varying agricultural seasonal patterns, weather conditions and weather-related pressure from pests, as well as customer marketing programs and requirements |
| Weather patterns can have an impact on our sales, particularly sales of our agricultural chemicals |
| The end users of some of our products may, because of weather patterns, delay or intermittently suspend field work during the planting season which may result in a reduction in the use of some products and therefore reduce our revenues and profitability |
| There can be no assurance that we will adequately address any adverse seasonal effects |
| We depend on our senior management team and the loss of any member could adversely affect our operations |
| Our success is dependent on the management and leadership skills of our senior management team, including David L Hatcher, our Chairman and Chief Executive Officer, J Neal Butler, our President and Chief Operating Officer, John V Sobchak, our Chief Financial Officer, and Roger C Jackson, our General Counsel |
| The loss of any member of our senior management team or an inability to attract, retain and maintain additional qualified personnel could prevent us from implementing our business strategy |
| We cannot assure you that we will be able to retain our existing senior management personnel or attract additional qualified personnel when needed |
| If we are unable to successfully negotiate with the labor unions representing our employees, we may experience a material work stoppage |
| More than half of our full-time employees who work at our facility in Matamoros, Mexico, where penta and certain other products are produced, are represented under a labor contract that is negotiated annually |
| We cannot assure you that a new agreement will be reached each year without union action, or that a new agreement will be reached on terms satisfactory to us |
| An extended work stoppage, slowdown or other action by our employees could significantly disrupt our business |
| Future labor contracts may be on terms that result in higher labor costs to us, which also could adversely affect our results of operations |
| We are subject to possible risk of terrorist attacks which could adversely affect our business |
| Since September 11, 2001, there have been increasing concerns that chemical manufacturing facilities and railcars carrying hazardous chemicals may be at an increased risk of future terrorist attacks |
| Additionally, federal, state and local governments have begun a regulatory process that could lead to new regulations impacting the security of chemical industry facilities and the transportation of hazardous chemicals |
| Our business could be adversely impacted if a terrorist incident were to occur at any chemical facility or while a railcar or tank truck was transporting chemicals |
| In addition, our business could be affected due to the cost of complying with new regulations |
| We are not insured against terrorist attacks, and there can be no assurance that losses that could result from a terrorist attack on one of our facilities, railcars or tank trucks would not have a material adverse effect on our business, results of operations and financial condition |
| 14 ______________________________________________________________________ Additionally, our business depends on the free flow of products and services through the channels of commerce |
| Recently, in response to terrorist activities and threats aimed at the United States, transportation, mail, financial and other services have been slowed or stopped altogether |
| Further delays or stoppages in transportation, mail, financial or other services could have a material adverse effect on our business, results of operations and financial condition |
| Furthermore, we may experience an increase in operating costs, such as costs for transportation, insurance and security as a result of the activities and potential activities |
| We may also experience delays in receiving payments from payers that have been affected by the terrorist activities and potential activities |
| The United States economy in general is being adversely affected by the threat of terrorist activities and any economic downturn could adversely impact our results of operations, impair our ability to raise capital or otherwise adversely affect our ability to grow our business |
| We are subject to risks inherent in foreign operations, including changes in social, political and economic conditions |
| We have facilities in the United States and Mexico, and generate a portion of our sales in foreign countries, primarily in Latin America |
| In fiscal year 2006, our production facilities in Matamoros, Mexico comprised approximately 34prca of our property, plant and equipment, and approximately 3prca of our net sales were in foreign countries |
| Like other companies with foreign operations and sales, we are exposed to market risks relating to fluctuations in interest rates and foreign currency exchange rates |
| We are also exposed to risks associated with changes in the laws and policies governing foreign investments in Mexico and, to a lesser extent, changes in United States laws and regulations relating to foreign trade and investment |
| While such changes in laws, regulations and conditions have not had a material adverse effect on our business or financial condition, we cannot assure you as to the future effect of any such changes |